There is no successful inventory management process operation that doesn’t first master the acquisition and careful usage of its raw materials.
Literally, there is none. Because it’s impossible.
Most businesses are in a race to acquire the lowest-cost material and drive operating costs down as far as they can. It’s not easy because it requires anticipating supply chain behavior. This is true for both B2B vs. B2C businesses.
And that all starts the management of your raw materials. Your turnover, COGS, and profitability all depend on effectively managing your raw materials inventory. It benchmarks your entire inventory management process.
What’s more, raw materials have a big impact on the overall health of your company. That’s because they’re recorded as a current asset on your balance sheet. It gives them an outsized impact on cash flow and end-period financial performance.
Raw materials, then, are the untouched clay of business, ready to be molded into economic art. Here’s what you need to know about them.
What Is Raw Materials Inventory: Raw Material Inventory Definition
The raw material inventory definition is stock that hasn’t yet been used for manufacturing. Often times business owners will obtain materials from a wholesale marketplace. Just make sure the businesses you purchase from have a valid wholesale license to avoid getting burned.
It has yet to be combined with human labor and turned into either work in process inventory or finished goods inventory. Those are the two other types of manufacturing inventory (see what is inventory).
That’s why the raw material inventory definition varies by company. It refers to the pre-production inventory—and that depends on what a company’s finished product is.
There are two types of raw materials inventory: direct and indirect.
Direct Raw Materials Inventory
Direct raw materials are all the materials that actually constitute the finished product. Take a coffee roasting business, for example. Their finished product is roasted coffee beans, and their raw materials inventory is green coffee beans.
Consider also a coffee machine manufacturer. Their finished products (or merchandise inventory) are functional coffee machines. Their raw materials inventory are the glass, plastic, and electric components that make up a coffee machine. Likewise, think of the cotton used to make cotton shirts or the glass used to make windows. This all needs to be considered when they price their monthly coffee subscription.
Indirect Raw Materials
Indirect raw materials inventory are all materials consumed during the production process but are not a part of the finished product. This includes things like disposable tools and protective equipment, light bulbs, cleaning supplies, fuel, and lubricants.
How to Calculate Raw Materials Inventory
To figure out how to calculate raw materials inventory, you’ll need to know:
- Beginning Raw Materials Inventory
- Raw Materials Purchased
- Cost of Goods Sold (COGS)
It's not so different from how to calculate finished goods inventory.
Beginning Raw Materials Inventory Formula
Remember that beginning raw materials inventory is the previous accounting period’s ending raw materials inventory.
To find your beginning raw materials inventory, use this beginning raw materials inventory formula:
Beginning Raw Materials Inventory = (COGS + Ending Raw Materials Inventory) - Raw Materials Inventory Purchased
How to Find Ending Raw Materials Inventory
Ending raw materials inventory is often what businesses are out to calculate. Keep in mind that ending raw materials inventory will be the beginning raw materials inventory for the next accounting period.
Here’s the ending raw materials inventory formula:
Ending Raw Materials Inventory = (Raw Materials Inventory Purchased + Beginning Raw Materials Inventory) - COGS
Let’s use a clothing manufacturer as an example.
Consider BlueCart Tee Shirt Co. They make and sell cotton tee shirts. They have a beginning raw materials inventory of $10,000. That’s $10,000 worth of cotton and the expendable resources used to turn cotton into shirts. Over the accounting period in question, they acquire $15,000 worth of raw materials. And, during the accounting period, $7,000 worth of finished goods was sold.
Raw Materials Inventory = $10,000 + $15,000 - $7,000
Raw Materials Inventory = $18,000
This means the total cost of all pre-production material BlueCart Tee Shirt Co. has on hand at the end of this accounting period is $18,000.
How to Calculate Raw Materials Inventory Turnover
Raw materials inventory turnover represents the rate at which raw inventory is used and then replaced. It’s a reliable measure of how accurate a business’s inventory forecasting and purchasing strategies are.
The raw materials inventory turnover ratio formula for a given time period is is:
COGS / Average Cost of Raw Materials Inventory
Where the average cost of raw materials inventory is
(Beginning Raw Materials Inventory + Ending Raw Materials Inventory) / 2
An inventory turnover ratio of between 4 and 6 is considered an ideal balance between sales and replenishment.
A raw materials inventory turnover rate higher than that means that a company’s raw materials are used and replaced frequently. Though that may also indicate a potential for costly backorders. A lower rate materials inventory turnover, alternatively, means that demand forecasting and purchasing planning are not properly coordinated. It is a vital part in a company's ability to hit their inventory KPI.
Raw Materials Inventory Accounting
Accounting for raw materials accurately helps businesses track that investment throughout the production process. That, in turn, gives an accurate picture of a company’s financial health. It all starts with tight raw inventory bookkeeping.
When raw materials are used up, the bookkeeping depends on whether they’re direct or indirect raw materials. Just make sure you know how to calculate markup when setting prices on the products you create.
What Kind of Asset is Raw Materials Inventory?
Raw materials inventory is kept on the balance sheet as a current asset. Initially, acquired raw materials of all types, both direct and indirect, are recorded with a debit to the raw materials inventory account and a credit to accounts payable.
Accounting for Direct Raw Materials
If you use direct raw materials, debit the WIP inventory account and credit the raw materials inventory asset account.
Accounting for Indirect Raw Materials
If you use indirect raw materials inventory, debit your overhead account and credit the raw inventory inventory asset account. Then, at the very end of the accounting period, the ending overhead balance is placed into COGS.
Accounting for Unusable Raw Materials Inventory
Sometimes, sadly, raw materials become so obsolete or degraded that they can no longer be used. When that happens, their cost is usually allocated directly to the COGS, with a credit to the raw materials account. This isn't affected by your inventory costing methods.
7 Tips on How to Manage Raw Material Inventory
At the risk of droning on: efficient inventory management starts with smart raw material inventory management. Here are seven tips for how to manage raw material inventory.
Use a Material Resource Planning Platform
Material planning is the science of determining the types and quantities of raw inventory needed for production. Both direct and indirect raw materials need stores of safety stock, buffer stock, and anticipation stock. Material Resource Planning (MRP) platforms analyze historical consumption data, lead time, modes of production, and supply chain complexity. They balance those with future forecasts to suggest optimal stock levels and purchasing cadences. This can work for other types of inventory, too, like MRO inventory.
Keep an Eye on Overstock and Understock
Perhaps unsurprisingly, overstock or understock means your raw material inventory management isn’t optimized.
If you have overstock, it means:
- Your sales forecasts are too optimistic
- Your estimated lead times are too high
- Your safety, buffer, or anticipation stock should be reduced
If you have understock, it means:
- Your forecasting failed to identify seasonal demand trends
- Lead times are taking too long due to pipeline inventory issues like transport delays, customs, or other freight complications
- Shortages from supplies upstream in the supply chain
Mind Quality Control
It’s not uncommon for a manufacturer to reject raw material from vendors due to quality or compliance (for electronics, for example) issues. Even if that manufacturer is in a current vendor managed inventory agreement with them. In those cases, an inventory shortage is all but inevitable.
Try not to cut costs on raw materials because the resultant costs of added labor and paused production—not to mention customer satisfaction—will dwarf it.
Automate Data Management
This is probably the most impactful decision you can make. Modern global supply chains are ridiculously complicated. There is no industry where manual inventory management and analysis cuts it.
Find an automated tool that offers:
- Demand forecasting
- Expansive data collection and analysis that collects data from all parts of the supply chain
- Intelligent costing functions to estimate total manufacture cost and inventory carrying cost
- For food and beverage businesses, tracing software that tracks product origin and provenance is often necessary
- Route optimization software can help eliminate too much time in transit
Focus on Raw and Finished Inventory First
Small-to-medium businesses are often overwhelmed by inventory management. So they do what they’re used to: try to do everything all at once. Don’t.
The lowest hanging inventory fruit for SMBs is raw material and finished goods. Focus on those first, then move on to tweaking your production process with WIP inventory optimization. But don’t go for WIP analysis first.
By analyzing pre- and post-production inventory, you’ll implicitly get a picture of your WIP inventory. Only after you’ve mastered raw and finished goods inventory should you slowly turn the screw on WIP inventory analysis.
Calculate Reorder Points for Safety Stock
Don’t replenish safety stock on a whim. Calculate hard reorder points so you know exactly when to order more safety stock. It’s the best way to ensure you’re not running out of inventory. And it lessens the cognitive load of inventory management. With reorder points, there’s no thinking. When you hit a predetermined inventory level, you reorder.
Don’t Account for Literally Everything
Some manufacturers have many different kinds of low-cost raw materials. So much, in fact, that accurately accounting for and tracking everything isn’t reasonable.
While high-cost raw material inventory should be on your production recipe or bill of materials, low-cost, indirect materials need not be accounted for precisely. Think of boxes upon boxes of individual screws. Feel free to cost something like that when they’re acquired en masse. That way you don’t have to worry about every single little piece during production.
Raw Materials Inventory Management: Find the Middle
How to manage raw material inventory is all about moderation.
Don’t make the mistake of thinking that having a bunch of extra raw materials lying around is insulating you from catastrophe. Cash tied up in sitting inventory like that could be weighing your business down in fatal ways. Perform a consistent inventory audit to avoid issues with managing raw inventory and always keep an eye on your fill rate.
The only way to be sure it’s not is to spin up a raw material inventory management operation so sound, so strategic, that there are no doubts.
Think of raw materials like food. Your business needs them to survive. But too much or too little can cause problems. That’s why virtually every manufacturer today relies on inventory management software to find a healthy middle ground. Increasing your sell through rate and lowering inventory shrinkage can also help lower the raw materials that build up in your storage. This is made easier by using a B2B eCommerce platform or an online wholesale marketplace. Even better, you can choose to use the dropshipping model so you never deal with raw materials or inventory again.